Most in the western world will agree that tackling climate change and social justice through appropriate governance is the way to make the world a better place.
This is why ESG criteria are now the golden standard to assess organisations’ and individuals’ adherence to these progressive values.
But is ESG really accelerating the change we all want to see? In this guide, we explain what ESG is, its history as well as its merits and flaws.
What is ESG?
Environmental, Social and Corporate Governance (ESG) is a framework designed to guide the decision-making of individuals, organisations, corporations and even governments in order to make them more progressive.
In other words, its a framework used to encourage the ensemble of the world to become more climate-friendly, more socially just, and have more participative yet efficient governance.
The idea is for the most influential institutions in the world (i.e. governments and asset managers) to use the framework to decide how to allocate their capital (i.e. who they give money).
“Money makes the world go around”, and theoretically, this framework prevents parties who oppose ESG values from receiving any financial help. And without money, nothing can operate.
What does ESG stand for?
ESG stands for Environmental, Social and Corporate Governance, with each of the criteria falling within one of the three letters of ESG.
Below are the general topics encompassed by each of the three criteria groups, which give an idea of what the general ESG framework is trying to encourage.
- Environmental criteria: Climate change strategy, biodiversity protection, water and energy management, carbon emissions, environmental management systems, sustainability.
- Social criteria: Equal opportunities, freedom of association, health and safety, human rights, customer and product responsibility, child labour.
- Governance criteria: Business ethics, compliance, board independence, executive compensation, shareholder democracy.
When did ESG begin?
ESG are essentially modern western values that organisations like the United Nations uphold and have been trying to encourage for almost a century.
This means that there are also many pre-ESG examples of organisations taking into account these modern values when allocating financing.
An example of this is the financial sanctions imposed by global powers like the US and the UK on South Africa during apartheid as it essentially opposed the concept of equal opportunities and human rights as per the Sullivan Principles drawn a member of General Motors’ board.
The formal ESG criteria as we know them to have their origins in a letter sent to the CEOs of the largest financial institutions by then UN Secretary-General Kofi Annan in 2004.
The recipients of these letters formed a coalition together with the World Bank, the UN and the Swiss government to produce the landmark 2005 report titled: Who Cares Wins, where the term was first coined and most of the core philosophy originates.
In 2006, the same coalition decided to go a step further and commit its members to sign to the Principles for Responsible Investment (PRI), which binds them to use the ESG criteria when deciding capital allocation.
The PRI currently has >4000 signatories, of whom 75% are influential asset managers. For those who are not aware, these financial institutions essentially run the world as they have the final say when deciding who gets funding.
To illustrate this point, the table below gives some perspective on the amount of capital that the top 5 global asset managers (all signatories to the PRI) handle yearly.
The top 5 asset management companies handle nearly 8% of ALL assets in the world, which includes money, infrastructure, shares, etc.
|Firm/Company||Assets under Management ($USD)||% of total global wealth (460 trillion $USD)|
|BlackRock||10.0 trillion $USD||2.2%|
|Charles Schwav||8.1 trillion $USD||1.8%|
|Vanguard||8.1 trillion $USD||1.8%|
|UBS||4.3 trillion $USD||1.0%|
|Fidelity||4.0 trillion $USD||0.9%|
When did ESG become relevant?
With increasing awareness (and effects!) of climate change, social justice and the impact of bad governance, there has been a significant increase in demand for ESG-compliant products during the last decade.
But many were worried that complying with ESG would lead to reduced profits and even financial viability for some businesses. However, this narrative has shifted as research focussing on the impact of ESG on financial returns has shown that in fact, the opposite may be true.
The graph below from PRI shows that this is clearly the case, with ESG-compliant assets under management increasing to >100 trillion dollars in 2020.
Some argue, however, that the turning point for ESG was Larry Fink’s 2020 letter to CEOs where he declared that Black Rock, the largest asset manager in the world, would start knuckling down on ESG capital allocation, forcing corporations across the spectrum to take ESG more seriously.
In fact, just one week after the letter, the initial 22 ESG metrics were standardised during the 2020 World Economic Forum (WEF) conference in reaction.
And in his latest 2022 letter, “The Power of Capitalism“, Larry Fink keeps emphasising adherence to ESG, insisting that companies that do not adapt would go “the way of the dodo”.
How is ESG compliance determined?
With the growth of ESG criteria when making judgements on assets, there has been a rise in companies that determine ESG ratings for corporations, in the same way as corporations are given credit rating scores given to companies and countries in terms of their financial sustainability.
The largest ESG ratings company is currently MSCI (Morgan Stanley Capital International), which gives corporations an ESG score ranging from AAA to CCC using 37 different criteria, which has recently been extended to individuals.
In this way, investors, consumers and voters are able to discern institutions and individuals based on their ESG reputation and decide accordingly.
What industries have the lowest ESG criteria?
There are certain industries that naturally struggle to fit into the ESG criteria as they are not focused on sustainability, fairness or, environmental consciousness.
Companies generally considered off-limits by ESG investors include those within the following industries:
However, it is worth noting that the structural complexity of some large corporations means that there are always indirect or obfuscated routes in which these industries can receive funding despite the ESG firewall.
Is ESG worsening the energy crisis?
There are many that accuse ESG investing of worsening the current energy crisis by redirecting investment away from oil & gas into other more sustainable streams, choking out the supply side of these fossil fuels.
Higher oil and gas prices certainly drive investment into the green energy transition by making renewables comparatively cheaper, but the issue is that our current infrastructure (transportation, heating, etc) still runs predominantly on fossil fuels and phasing them out too fast is an underlying cause of the energy crisis.
To put it into perspective, capital spending on traditional energy companies peaked in 2015 at $400 billion and shrank to $120 billion in 2021, even when global demand for fossil fuels keeps rising.
And the perfect storm was set when Russia invaded Ukraine earlier this year, further reducing the supply of fossil fuels to Europe.
However, ESG is certainly not the only reason for the energy crisis. Bureaucracy, corruption and a general delay in capital redirection have also slowed down the transition. Unfortunately, humans only act once the pressure is on, and not when logic states it’s a good idea.
Is ESG a sham?
Unfortunately, as good of an idea ESG is in theory, as the use of its criteria percolates top down through the many layers of human-affected reality, we end up with something far from ideal.
CEOs who often had some freedom to pivot in adequate ways are now weighted down by another set of standardised criteria set by its in-house ESG board (now ubiquitous in all medium to large businesses), who are often hard-liners with no leniency to the often complex interactions between finance and ESG.
As renowned journalist Alan Murray puts it in his latest book “Tomorrow’s Capitalists“, most CEOs nowadays understand the real importance of tackling climate change and are willing to go the extra mile without the need for institutionalised pressure.
There is also criticism that ESG is empowering the more extreme eco-warriors out there who demand immediate change without regard to sustainability.
As Ex-SEC Commissioner Hester Peirce puts it: ESG-shaming is like “public shaming, and shunning wrapped in moral rhetoric preached with cold-hearted, self-righteous oblivion to the consequences, which ultimately fall on real people”.
Lack of credibility
Another issue with ESG is that, somehow, large companies that would normally score low on social and governance metrics are still included in many ESG funds.
Examples include the largest tech giants, Microsoft, Google, Apple and Facebook, who are largely regarded as constantly breaching users’ privacy and data protection, which ultimately has large social implications.
The reason for this is that these companies often perform stellarly on the ‘E’ (environmental) criteria, as many of them are gradually approaching net-zero emissions and, in fact, do much for sustainability, but often at the expense of other metrics.
Which ESG certificate is best?
There is no such thing as an “ESG certificate” that an organisation or individual can receive for its ESG credentials.
However, an ESG credit score is now available, which judges institutions and even individuals on their ESG compliance, in a similar way Moody‘s gives out financial credit scores given out to institutions.
When it comes to becoming someone who credibly understands ESG, IASE (International Association for Sustainable Energy) appears to be giving out qualifications showing ESG expertise.
Why is ESG important?
ESG is important because it’s a great tool to assess compliance with universally accepted environmental, social and governance practices and, therefore, an important way in which to drive change.
And there is urgency on the ‘E’ side as climate change requires action to prevent it from being totally catastrophic to humanity.
Will ESG go away?
This is very unlikely, as ESG criteria are widely accepted as being necessary for change and its being shilled by the most influential institutions in the world, such as large asset managers like Black Rock, the US government and the United Nations.
There is a chance that ESG will be gradually amended to be more effective, but we would say that its disappearance is virtually impossible.
Are there other terms for ESG investing?
Although ESG investing refers specifically to investments that consider the specific criteria defined by the PRI, other terms such as sustainable investing, responsible investing, impact investing and socially responsible investing (SRI) are commonly tossed around.
The reason for this is that all of these other terms overlap with the ESG criteria, as it represents the modern values that western civilization aims to uphold.
Principles for Responsible Investment (PRI)
“A Fundamental Reshaping of Finance” – BlackRock letter to CEOs 2020
“The Power of Capitalism” – BlackRock letter to CEOs 2022
Tomorrow’s Capitalist: My Search for the Soul of Business